Financial Statements and Business Decisions

Chapter 01

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin 1-1

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Understanding the Business

The Players
Investors Creditors
Managers
1. Purchase parts and labor 2. Manufacture product

The Business Operations

4. Collect cash from customers and pay creditors
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3. Sell products to customers

The Accounting System

Managers (internal decision makers)

Collects and processes financial information

Reports information to decision makers

Investors and Creditors (external decision makers)

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The Accounting System

Accounting System

Financial Accounting Reports

Periodic financial statements and related disclosures

Managerial Accounting Reports

Detailed plans and continuous performance reports

External Decision Makers

Investors, creditors, suppliers, customers, etc.

Internal Decision Makers

Managers throughout the organization

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The Four Basic Financial Statements

1. BALANCE SHEET reports the amount of assets, liabilities, and stockholders equity of an accounting entity at a point in time. 2. INCOME STATEMENT reports the revenues less the expenses of the accounting period. 3. STATEMENT OF RETAINED EARNINGS reports the way that net income and distribution of dividends affected the financial position of the company during the accounting period. 4. STATEMENT OF CASH FLOWS reports inflows and outflows of cash during the accounting period in the categories of operating, investing, and financing.

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The Accounting Equation

A = L + SE
(Assets) (Liabilities) (Stockholders Equity)
Economic Resources Sources of Financing for Economic Resources
Liabilities: From Creditors Stockholders Equity: From Stockholders

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The Balance Sheet

Typical Account Titles

Assets Cash Short-Term Investment Accounts Receivable Notes Receivable Inventory (to be sold) Supplies Prepaid Expenses Long-Term Investments Equipment Buildings Land Intangibles
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Liabilities Accounts Payable Accrued Expenses Notes Payable Taxes Payable Unearned Revenue Bonds Payable

Stockholders Equity Contributed Capital Retained Earnings

Balance Sheet
MAXIDRIVE CORP. Balance Sheet At December 31, 2010 (in thousands of dollars) ASSETS Cash Accounts receivable Inventories Plant and equipment Land Total assets LIABILITIES Accounts payable Notes payable Total liabilities STOCKHOLDERS' EQUITY Contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity
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$ $

4,895 5,714 8,517 7,154 981 27,261 7,156 9,000 16,156 2,000 9,105 11,105 27,261

The Income Statement

Typical Account Titles

Revenues Sales Revenue Fee Revenue Interest Revenue Rent Revenue

Expenses Cost of Goods Sold Wages Expense Rent Expense Interest Expense Depreciation Expense Advertising Expense Insurance Expense Repair Expense Income Tax Expense

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Income Statement
MAXIDRIVE CORP. Income Statement For the Year Ended December 31, 2010 (in thousands of dollars) Revenues Sales revenue Total revenues Expenses Cost of goods sold expense Selling, general, and administrative expense Research and development expense Interest expense Total expenses Operating income Income tax expense Net income $ 37,436 37,436 26,980 3,624 1,982 450 33,036 4,400 1,100 3,300

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Statement of Retained Earnings

Beginning Retained Earning Plus: Net Income Less: Dividends Ending Retained Earnings

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Statement of Retained Earnings

MAXIDRIVE CORP. Statement of Retained Earnings For the Year Ended December 31, 2010 (in thousands of dollars) Retained earnings, January 1, 2010 Net income for 2010 Dividends for 2010 Retained earnings, December 31, 2010 $6,805 3,300 (1,000) $9,105

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Statement of Cash Flows

MAXIDRIVE CORP. Statement of Cash Flows For the Year Ended December 31, 2010 (in thousands of dollars) Operating activities Cash collected from customers $ Cash paid to suppliers and employees Cash paid for interest Cash paid for taxes Net cash flow from operating activities Investing Activities Cash used to purchase equipment Net cash flow from investing activities Financing Activities Cash received from bank loan Cash dividends paid Net cash provided by financing activities Net increase in cash Cash at beginning of year Cash at end of year $
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33,563 (30,854) (450) (1,190) 1,069 (1,625) (1,625) 1,400 (1,000) 400 (156) 5,051 4,895

Relationships Among the Statements

1. Net income from the income statement results in an increase in ending retained earnings on the statement of retained earnings.
Income Statement Revenues $ 37,436 34,136 Expenses Net income $ 3,300
Statement of Retained Earnings Beginning retained earnings $ 6,805 Net income 3,300 Dividends (1,000) Ending retained earnings $ 9,105

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Relationships Among the Statements

2. Ending retained earnings from the statement of retained earnings is one of the two components of stockholders equity on the balance sheet.
Statement of Retained Earnings Beginning retained earnings $ 6,805 Net income 3,300 Dividends (1,000) Ending retained earnings $ 9,105 Balance Sheet Cash Other assets Total assets Liabilities Contributed Capital Retained earnings Total liabilities and equity $ 4,895 22,366 $ 27,261 $ 16,156 2,000 9,105 $ 27,261

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Relationships Among the Statements

3. The change in cash on the statement of cash flows is added to the beginning-of-year balance in cash to arrive at end-of-year cash on the balance sheet.
Statement of Cash Flows Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities Change in cash Beginning cash balance Ending cash balance Balance Sheet $ 1,069 (1,625) 400 $ (156) 5,051 $ 4,895 Cash Other assets Total assets Liabilities Contributed Capital Retained earnings Total liabilities and equity $ 4,895 22,366 $ 27,261 $ 16,156 2,000 9,105 $ 27,261

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Notes
All financial statements should be accompanied by notes which provide the reader with supplemental information about the financial condition and results of operations of the company.

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Management Uses of Financial Statements

Marketing managers and credit managers use customers financial statements to decide whether to extend credit.

Purchasing managers use suppliers financial statements to decide whether suppliers have the resources to meet the demand for products.

Employees union and human resource managers use the companys financial statements as a basis for contract negotiations over pay rates.
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Summary of the Financial Statements

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Responsibilities for the Accounting Communication Process

The Rules

Generally Accepted Accounting Principles (GAAP)

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How are Generally Accepted Accounting Principles Determined?

Our accounting system has a long and distinguished history. An Italian monk named Luca Pacioli, published the first elements of double-entry bookkeeping in 1494. Prior to 1933, the management teams of most companies were largely free to choose their own financial reporting practices.

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Generally Accepted Accounting Principles

Securities Act of 1933 Securities and Exchange Act of 1934

The Securities and Exchange Commission (SEC) has been given broad powers to determine measurement rules for financial statements.

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Generally Accepted Accounting Principles

The SEC has worked closely with the accounting profession to work out the detailed rules that have become known as GAAP.

Currently, the Financial Accounting Standards Board (FASB) is recognized as the body to formulate GAAP.

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Generally Accepted Accounting Principles

Companies incur the cost of preparing the financial statements and bear the following economic consequences . . .

Effects on the selling price of stock. Effects on the amount of bonuses received by managers and other employees. Loss of competitive information to other companies.
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International Perspective
International Financial Reporting Standards
Since 2002, there has been substantial movement toward the adoption of International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB).
Examples of jurisdictions requiring the use of IFRS either currently or by 2012 include: European Union Australia and New Zealand Hong Kong, India, Malaysia, and South Korea Israel and Turkey Brazil and Chile Canada and Mexico In the United States, the Securities and Exchange Commission now allows foreign companies whose stock is traded in the U.S. to use IFRS and is considering requiring the use of IFRS for U.S. domestic companies by 2014.
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Management Responsibility and the Demand for Auditing

To ensure the accuracy of the companys financial information, management: Maintains a system of controls. Hires outside independent auditors. Forms a committee of the board of directors to review these two safeguards.

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Independent Auditors
Auditors express an opinion as to the fairness of the financial statements. Independent auditors have responsibilities that extend to the general public. The PCAOB issues detailed auditing standards that auditors must follow.
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Overall, I believe these financial statements are fairly stated.

Independent Auditors
An audit involves . . .
Examining the financial reports to ensure compliance with GAAP. Examining the underlying transactions incorporated into the financial statements. Expressing an opinion as to the fairness of presentation of financial information.

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Ethics, Reputation, and Legal Liability

The American Institute of Certified Public Accountants requires that all members adhere to a professional code of ethics.

Code of Ethics
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Ethics, Reputation, and Legal Liability

A CPAs reputation for honesty and competence is his/her most important asset.

Like physicians, CPAs have liability for malpractice.

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Supplement A: Types of Business Entities

Sole Proprietorship: owned by a single individual.

Partnership: owned by two or more individuals.

Corporation: ownership represented by shares of stock. Advantages of a Corporation

Limited liability
Continuity of life Ease of transfer of ownership Opportunity to raise large amounts of money Disadvantage of a Corporation Double taxation
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Supplement B: Employment in the Accounting Profession Today

Professional Designations CPA CMA CIA

Career Opportunities
Public Accounting Audit and Assurance Services Management Consulting Services Tax Services Employment by Organizations Internal accounting External reporting Tax planning Various other functions Employment in the Public and Notfor-Profit Sector

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End of Chapter 01

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